Wednesday, November 16, 2011

A Bad Case of Euro Fatigue?

Stocks fell on Wednesday in another low volume day, with selling accelerating late in the session on more warnings about the potential impact of the euro zone's debt crisis on the economy and the banking system:

Stocks fell on Wednesday, with selling accelerating late in the session on more warnings about the potential impact of the euro zone's debt crisis on the global economy and the banking system.

Worries about growth weighed on sensitive sectors like financials and materials. Losses deepened after ratings agency Fitch said even though the outlook on the U.S. banking industry is stable, it could worsen if the euro-zone's debt crisis is not resolved quickly.

Earlier, Moody's cut ratings on various German public sector banks, citing a lower likelihood of external support if it were required.

Joe Saluzzi, co-manager of trading at Themis Trading in Chatham, New Jersey, cited both rating agencies' moves as catalysts for the sharp selloff in late trading.

Fears are growing that the euro zone's crisis is moving to economies that had been considered more protected from the problems. The yield spread of 10-year French government bonds over their German equivalents widened to a euro-era high.

Markets sagged overnight as investors reacted to rising yields overseas. The concern is that euro-zone leaders will be unable to enact reforms to reduce debt and promote growth. The U.S. equity market's swings have become increasingly tied to gyrations in European credit markets.

About 7.4 billion shares traded on the New York Stock Exchange, NYSE Amex and Nasdaq, below this year's daily average of 8 billion shares.

Not only is the market, as of mid-November, more or less where it stood at the beginning of the month, trading volume has been unusually light.

And that has some analysts worried. If a new bull market did indeed begin at the early October lows, as some commentators argue, and if volume had picked up as much as it did in prior bull markets, then we should be seeing markedly higher trading volume right now.

That we’re not suggests to some that the rise since the October lows is more likely to be a bear market rally than the beginning of a major new bull market.

To find out how worried we should be, I analyzed stock-exchange volume at the beginning of all bull markets since the early 1970s. I relied on the precise definition of a bull market that is employed by Ned Davis Research, the quantitative research firm, according to which there have been 10 bull markets since the mid 1970s.

For each of these bull markets, I calculated a ratio of two numbers: The first is average daily NYSE trading volume over the first six weeks of that bull market, and the second is the average over the six weeks prior to the bull market’s beginning (that is, in the last six weeks of the preceding bear market). I chose these six-week windows because that is how much time has passed since the early October lows.

Across all 10 past bull markets, this ratio’s average was 2.15 to 1. That means that trading volume was more than twice as high in the first six weeks of the average past bull market than in the six weeks of the preceding bear market.

How does this compare to what we’re experiencing today? The ratio of average daily trading volume in the six weeks since the October low to the average in the six weeks prior to that was 1.87 to 1 — 13% lower than this ratio’s average and lower than the minimum this ratio has been at the beginning of any of the last 10 bull markets.

Ned Davis Research measures volume trends differently, but reaches the same conclusion. The firm calculates a ratio of volume’s 50-day moving average to its 200-day average. This ratio currently stands at 1.04-to-1. In contrast, according to the firm, the best stock market gains historically have been produced when this ratio is above 1.05-to-1.

To be sure, regardless of which way volume is measured, recent volume is only slightly to moderately below the minimum we would expect if the last six weeks represented the beginning of a new bull market.

So light trading volume raises more concerns than outright alarms.

At a minimum, though, recent volume trends suggests that — regardless of what we call it — the six-week-old rally is not a particularly strong one.

Trading volume in S&P 500 SPDR etf (SPY) --otherwise known as "spiders" over the past week is 25% below its 3-month average.

While nervousness about stocks and a reluctance to buy into a market that's up 15% in 6 weeks may seem obvious, there is a unique and unusual rift in this trading trend that is both telling and potentially optimistic. Specifically, that volume is light only on the buy side, while sell volume is actually running above average. It brings to mind the old adage that fear of getting hit by the bus is greater than fear of missing the bus, as it pertains to the investor confidence.

As Macke and I discuss in the attached clip (see below), there a numerous inferences that can be drawn from the overall dearth of trading and the bias we have uncovered towards selling.

First, that with only six holiday-crimped weeks left in the year, fund managers are simply running out of time to beat their benchmarks and are practically begging for a reason to buy, and will return in size the moment they find one. At the same time, even a whiff of weakness sends investors fleeing towards the exit.

A quick look at November's biggest winners and losers confirms this bias against buying, with 8 of the top 10 gainers showing volume decreases in the past week versus their 3-month averages. At the same time, a comparable 80% of the top 10 decliners have seen an increase in short-term volume versus the long-term average.

The takeaway from all of this voluminous research, at least in Macke's view, is that the odds of the market breaking out now look better than it breaking down. He's now adding to his position in the Nasdaq 100 etf (QQQ) and Spiders (SPY). At the same time, we both accept the idea that, in terms of ranges and levels, S&P 500 at "1270 is the new 1250" and any move above that point will see buyers rushing back in, in size.

Of course, any unforeseen shock is always a threat to the downside, but with markets largely holding their ground and reports of "crisis fatigue" reaching pandemic levels, it may just be time to find something else to worry about for a while.

Today it was reported that unemployment in the UK is at 15-year highs and Spanish, French and Italian bond yields refuse to move significantly lower, regardless of ECB intervention. Stocks should be lower, but stubbornly refuse to break. Does this mean the European meltdown is "the new normal" allowing the U.S. to focus on our slightly better than expected earnings and economic news? At long last is there enough "crisis fatigue" to let us buy stocks in good conscience?

To help answer these questions and more Breakout turned to Minyanville's Todd "Todd-O" Harrison, author of The Other Side of Wall Street. Harrison, who freely describes himself as a longtime bear, suggests the market may be buoyed by a delay in Europe's eventual collapse. "A lot of things can happen; not many of them are good but most of them will get us through this phase," Harrison says.

Having known Harrison for the better part of a decade I can say with certainty that his "get us through this phase" is the equivalent of another man's "Buy 'em, Baby!" But he's more cautiously guarded.

"Be careful of the the fatigue factor because it's lulling you into a false sense of security," says Harrison. In his view, the market won't be able to shake off a collapse in the anger of the populous forever. "Social mood and risk appetites shape financial markets," he says. And eventually markets are destined to break lower.

Europe seems to be heading towards measures that will lead to austerity, belt-tightening and other traditionally bearish situations. By this thinking, Europe coming up with a coherent plan may be the worst thing that could happen to stocks.

This doesn't make Harrison a bear, just a trading long. Along with the rest of the civilized trading planet he's watching S&P500 1,220 and the KBW Banking index (^BKX) at 40 as critical support. Unless those levels break he's sticking to the long side while "trading small and keeping risk tighter."

Over the course of 2011, the idea that the euro is soon to become obsolete has gone from a crackpot theory to conventional wisdom. At least that's the way money managers are playing it, according to Marc Chandler, global head of currency strategy at Brown Brothers Harriman. "A lot of hedge funds, a lot of speculators, have been betting the euro's gong to fail," Chandler says.

Beware conventional wisdom. Despite, or perhaps because of the popularity of the "short euro" trade, the currency remains fairly resilient. To paraphrase the question being asked on trading desks worldwide: "What in the name of all that is holy is holding the euro up?"

Here are Chandler's three reasons:

1. European banks are bringing money home, whether they want to or not. It's all about capital requirements. The one thing European officials seem able to agree on is that banks need more liquidity. Forced to come up with more money, traders sell what they can, not what they want. Given the choice between dumping foreign debt into a weak market or selling liquid American assets banks will choose the former.

2. The dollar may be worse than the euro. "People are still worried about QE3 in the United States," says Chandler. Putting it less gently, America's ability to devalue the dollar actually exceeds the pace of the euro's organic demise. Ugh.

3. U.S. yields are still so low as to make buying our debt largely pointless. Chandler says when Americans invest overseas they buy equities whereas foreigners tend to favor our bonds over our equities. With an ever devalued buck, being long Treasuries literally cost foreign investors money.

All that said, Chandler thinks the euro will break to $1.29 versus current levels in the mid-$1.30s. Six cents may seem like nothing but it's a huge move in currency markets. As we've mentioned on Breakout roughly every other day since at least last April, "strong dollar = weak stocks." Chandler confirms the observation and uses real numbers to support it.

Using R-squared, 60-day rolling correlations and other wonky calculations, the currency guru says "the euro and the S&P500 are the highest correlated ever." While that implies a nearly catastrophic move lower in U.S. equities, history suggests that trade is half-again too obvious. We've seen "periods of inverse correlation in the past and we will see them again," he says. We better see inverse correlation soon or it's going to be a bumpy ride between now and the end of the year.

Whether it's the pushy paparazzi chasing movie stars, endless travel for pro athletes or baseless malpractice lawsuits against top doctors, every racket seems to have its shortcomings; a so-called cost of doing business. And the investment business is no exception, where gripes about turmoil and inexplicable price swings are often met coldly with "deal with it."

So if the European debt crisis has muddled your plans and the threat of recession has deferred your riches, don't go crying to John Manley, chief equity strategist at Wells Fargo Advantage Funds.

"If you want to be in it for the long-term you just have to put up with the volatility," Manley says in the attached clip, inferring what should be obvious to all investors; if it was easy we'd all be rich.

But of course it's not, even though Manley has a way of making it sound that way, as he draws on over 30 years of Wall Street wisdom to keep you from bailing out. One piece of advice he offers is to separate what you can and can't know about the future when trying to make decisions.

For example, Manley is certain that things are volatile, he knows that valuations are closer to the low-end than the high end, and is positive that it feels unpleasant to invest. "It's obviously not a top but we can't know if it is a bottom," he says.

More specifically, if Europe is the preeminent source of investor angst right now, in a game that hates uncertainty more than anything, then perhaps it's time to worry about something else. "We know everything about Europe's problems except how to fix them," Manley quips.

Domestically he's not calling for a recession because consumers are still spending. But he advises laying off retail stocks until after Christmas.

Additionally, if you're expecting a big drop in crude oil or big solutions from the Super Committee, you might be disappointed. Manley's thinking on the latter being that the painful measures needed to right the country's fiscal ship will only be taken when we reach a point where it hurts less to do it then not to.

I embedded all four clips below. My own sense is that markets want to rally but portfolio managers and traders are playing it safe waiting for some good news to finally come out of Europe in terms of a more solid, credible long-term debt plan. They might be waiting a long time for that as France and Germany sort out their differences.

In the meantime, I'm betting markets will slowly climb the wall of worry and move past euro fatigue. Investors should take the time to go through Leon Cooperman's presentation on the risks to equity market outlook. He thinks investors are "conservatively postured" and I agree.

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